GLOBAL MARKET REVIEW
The second quarter of 2022 was marked by uncertainty, as geopolitical factor risk spiked along with persistent global inflation. Central banks across the world, with the exception of Japan, took swift action by tightening monitor policy and raising interest rates, thereby causing investors’ concerns that an economic slowdown or recession was imminent. Those concerns were reflected across all risk markets, as risk premiums widened, as risk-free rates increased and as growth assumptions were dialed down. Unlike in the first quarter, real estate investment trusts (REITs) were not immune to the global risk drawdown and were down 17.4%.
When we thought about the portfolio in the quarter, we really had to keep in mind the economic and factor risks. What was not necessarily going to drive performance for the quarter were fundamentals. Real estate fundamentals typically drive REIT performance, but during certain periods, REIT performance will separate from fundamentals and trade more on economic factors and geopolitical risk.
The good news is that REIT prices across the world trade at substantial discounts to private real estate values and in many cases, near historically deep discounts from real estate value. We do expect some level of price correction in the private real estate markets, but listed REITs have already taken their price corrections and likely overreacted by implying a large increase and cap rate and a significant deterioration in net-operating income growth.
With regard to regional positioning during the quarter, we were underweight Europe, and that worked to our advantage. We created positive alpha as a result of being underweight Europe, overweight North America and neutral Asia. In Europe, the really big and important shift for us was an underweight in Germany. We had had this on for much of the second half of last year and the first quarter of 2022, but we increased our conviction around it.
When you think about Germany as part of the countries we invest in, Germany has the most-direct impact on or exposure to the Russian invasion of Ukraine in that Germany is very dependent on oil it receives from Russia. PGIM Real Estate has no direct exposure to Russia because we do not invest in Russian securities. Neither do we invest in any of the Baltic republics directly. Russia–Ukraine exposure in our portfolio lies in second-derivative dependences in areas like Germany, and our underweight position resulted in outperformance.
Interest rates spiked significantly in the quarter, and we are very mindful of how that affects real estate prices. Headlines have said mortgage rates are going up significantly, and the main area we have identified at this point is where the impact would be on M&A activity. As debt costs go up, highly levered buyers will have a harder time financing transactions, and so we’ve seen that some of that M&A activity that had been a theme has stalled a bit. The good news is that as rates have gone up, we are in a period in which a lot of landlords have pricing power. In this inflationary environment, reflation has been historically very good for real estate and REITs. We are seeing a lot of companies continue to deliver strong top-line revenue growth because occupancies are tight and supply is still not keeping up with demand.
In areas like self-storage, which have monthly rents, significant price increases are going on to the tune of double digits, which is quite small on a nominal-dollar basis but which on a percentage basis amounts to large increases. Storage companies have pricing power and very low risk to inflationary pressure on their cost structures, particularly wage inflation, because there usually are not many employees, if any, at the property. Therefore, they are not very vulnerable to things like wage inflation.
With regard to general backdrop, reflation/inflation is a good environment for real estate. Many long-term real estate leases have inflationary bumps built into them. Therefore, a protection is built right into the lease. For example, many industrial-space and warehouse-space five-year leases are being signed today with 4% to 6% annual rent increases. This is unlike a bond, which has a fixed payment and no opportunity to adjust to inflation. If rates and inflation go up, there is going to be a negative impact on a bond, but real estate can adjust either contractually or based on market conditions. An example is self-storage with 30-day leases. When they have pricing power, like now, they are getting above inflationary top-line growth, and their cost structure is not too vulnerable to inflation, which results in a favorable environment. In addition, the cost to build in an inflationary environment increases significantly. As a result, there is a muted supply effect and demand that generates pricing power that can either be in line with or exceed inflation. It’s a powerful place to be in a reflationary environment.
We are looking for companies that have the following four characteristics: (1) Defensive tenant demand that is needs based, like shelter and health care. (2) Pricing power above inflation. We are seeing double-digit rent growth in apartment, self-storage and assisted-living properties. (3) An expense line that is less exposed to inflation. Self-storage has limited wage labor risk, and triple-net-lease companies can pass energy and utility expenses through to tenants. (4) Substantial discount to private real estate value. Many property types, even those that are in high demand by private real estate investors, like apartments and industrial, trade at significant discounts to their private real estate value.
We also continue to monitor REIT balance sheets and are factoring in refinancing risks to earnings estimates.
Additionally, as mortgage rates increase, home affordability decreases, which skews the rent-to-own equation in favor of renting. This should cause more individuals and families to move into the renter market, which will benefit single-family rental and apartments.